[April 15, 2013] TELETOUCH COMMUNICATIONS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) Management's discussion and analysis of results of operations and financial condition is intended to assist the reader in the understanding and assessment of significant changes and trends related to the results of operations and financial position of the Company. This discussion and analysis should be read in conjunction with the consolidated financial statements and the related notes and the discussions under "Critical Accounting Estimates," which describes key estimates and assumptions we make in the preparation of our financial statements. The Company's third fiscal quarter begins on December first andends on February twenty-eighth. Executive Summary We are a regional provider of wireless telecommunications products and services. For over 48 years, Teletouch has offered a comprehensive suite of wireless telecommunications solutions, including cellular, GPS-telemetry and wireless messaging. Today, Teletouch is a primary Authorized Services Provider and billing agent of AT&T products and services to consumers, businesses and government agencies, operating 8 "Hawk Electronics" branded retail and customer service locations in North and Central Texas under its "Hawk Electronics" brand, in conjunction with its direct sales force, call center operations and various retail eCommerce websites including: www.hawkelectronics.com, www.hawkwireless.com and www.hawkexpress.com. 43 Through its wholly owned subsidiary, Progressive Concepts, Inc., Teletouch operates a national distribution business, PCI Wholesale, primarily serving Tier-1 (AT&T, T-Mobile, Verizon, Sprint) cellular carrier agents, Tier-2 and Tier-3 rural carriers, as well as auto dealers and smaller consumer electronics retailers, with product sales and support available through www.pciwholesale.com and www.pcidropship.com, among other B2B oriented websites. The Company experienced significant liquidity and going concern issues over the last year, primarily as a result of the acceleration of its debt obligations by its senior lender, Thermo Credit, LLC ("Thermo"), the maturity of its real estate debt with East West Bank ("East West") and Jardine Capital Corporation ("Jardine") and the State of Texas (the "State") sales and use tax audit assessment. Despite these issues, the Company improved its underlying operating results from its continuing operations in the three and nine months ended February 28, 2013 compared to the same periods from the prior fiscal year after excluding the $10,000,000 gain and the related $1,400,000 in management bonuses awarded as a result of the settlement with AT&T in November 2011 and the accrual of approximately $2,147,000 related to PCI's Texas sales and use tax audit issues in the third quarter of fiscal year 201. In the third quarter of fiscal year 2013, the Company made significant strides toward resolving its solvency matters by entering into a new senior credit facility, amending its debt with Thermo and negotiating a reduced Texas sales tax audit assessment and payment schedule to the State related to PCI's sales and use tax obligation. As a result of the financing transactions, the Company was able to make an initial draw-down of $4,3000,000 under the new revolving credit facility with DCP Teletouch Lender, LLC ("DCP") on February 8, 2013, of which $4,000,000 was used to pay down a portion of the Company's current indebtedness to Thermo. The remaining proceeds were used to pay certain closing costs to DCP and other professional fees. In addition, on January 7, 2013, the Company entered into a settlement agreement (the "Sales Tax Agreement") with the State which reduced the Company's sales tax assessment to approximately $1,414,000 and allowed the Company to pay the assessment back to the State in monthly installments. Although the Company has resolved its senior debt and sales tax obligation issues, it has not identified or secured a commitment from a new lender for financing its real estate as of the date of this Report. The Company's real estate loans with East West Bank and Jardine Capital Corporation initially matured on May 3, 2012 (reference the "Liquidity and Capital Resources" section within Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations, for more information on the Company's debt restructure, Sales Tax Agreement with the State and real estate debt). As of February 28, 2013, the Company's senior and subordinated debt obligations totaled approximately $7,211,000 and the accrued sales tax liability related to the PCI's sales tax audit was approximately $1,265,000, including assessed penalties and interest of $498,000, which is considered a contingent liability until the final payment has been under the tax settlement agreement at which time the State has agreed to forgive these penalties and interest. In addition, the Company's real estate debt was approximately $2,608,000 as of February28, 2013. Beginning February 2012, the Company has primarily focused on securing a new senior lender since Thermo noticed the Company of its intent to accelerate their senior revolving debt. The acceleration of this debt came shortly after the November 2011 settlement of the Company's litigation against AT&T and during a period when the Company planned to focus on and invest in growing its cellular subscriber base and maximize the value of the extended distribution agreement with AT&T, which was negotiated under the terms of the November 2011 settlement with AT&T. During the over 2 year period of litigation, the Company experienced a significant loss of cellular subscribers and related revenues. With the acceleration of the debt and the required pre-payments on the Thermo debt, the Company no longer had the cash available to make these investments in acquiring new subscribers through expanded distribution locations and additional investment in subsidized cellular phones for each new subscriber. Even with a limited number of activations of the then heavily subsidized iPhone, among other operational challenges, the operating results of the Company continued to suffer following the settlement with AT&T and through the third quarter of fiscal year 2012. The weak operating results for the third quarter of fiscal year 2012 delayed the Company in attracting a new lender willing to extend sufficient credit to the Company to retire the Thermo debt. During the fourth quarter of fiscal 2012, a new program was introduced by AT&T under which the Company was reimbursed for almost half of the subsidy required on the iPhone. This AT&T reimbursement program, combined with certain price increases implemented on certain charges billed to the cellular subscriber base and tighter cost controls resulted in significant improvement in the operating results for the fourth quarter of fiscal year 2012 and which continued on through the first quarter of fiscal year 2013. Income declined in the second quarter of fiscal year 2013, which is primarily due to additional and significant cellular handset subsidies caused by an increase in the number of subscriber contract renewals beginning in October 2012 largely due to the launch of the iPhone 5. Even though the Company benefits from the AT&T equipment subsidy reimbursement program, the increased number of subscriber contract renewals and the corresponding subsidies on the iPhone and other models of cellular phones in the second quarter of fiscal year 2013 exceeded the Company's other cost savings measures during the period. The Company improved its consolidated operating results in the third fiscal quarter compared to the second fiscal quarter by aggressively managing and reducing the number of subsidized cellular phones sold to customers by limiting new customer activations and applying stringent qualifications before an existing customer would qualify for a new subsidized phone. 44 Although revenue from the Company's cellular business has continued to decline throughout fiscal year 2013, the cellular operation's revenue improved slightly in the nine months ended February 28, 2013 compared to the same period from the prior fiscal year primarily due to price increases implemented in March 2012 on certain of the Company's services and fees billed to its cellular subscriber base and a reduction of costs following the closure of four Hawk stores in June 2012. The actions partially offset the loss of revenues caused by fewer cellular subscribers. Until the implementation of the price increases in the fourth quarter of fiscal year 2012, revenues in the cellular business eroded throughout fiscal year 2012 due to the inability to add a sufficient number of new cellular subscribers to offset the continued attrition of cellular subscribers following its completion of the litigation with AT&T in November 2011. Under the provisions of this settlement with AT&T, the Company can no longer transfer cellular subscribers from AT&T, which has negatively impacted new subscriber additions. Since there will be continuing limitations to expand the Company's subscriber base prior to the expiration of the AT&T distribution agreement in November 2014, the Company is concentrating its efforts on growing its wholesale distribution business in an attempt to help offset the declining revenues and loss of operating margins in its cellular business. The Company has been successful negotiating several national and exclusive geographic distribution agreements to sell cellular handset, cellular accessory and car audio product lines. During the first quarter of fiscal year 2013, the Company was successful in hiring several key sales and management personnel with strong backgrounds in the cellular handset distribution business. Although the Company was able to launch several new product lines and find knowledgeable personnel in early fiscal year 2013, the Company has not realized sales or income growth it expected from its wholesale business to date. Even though the Company has been successful in the wholesale distribution business in prior years, there is a strong market competition among wholesale distributers, and currently the Company's product mix, sales and marketing efforts have not been effective in generating the sales and profit it needs to help offset the declining profitability in the Company's cellular business. The Company's current focus is on finding wholesale products that will maximize its profits quickly and provide large scale distribution opportunities. In the later part of the third fiscal quarter, the Company began making personnel changes in its wholesale business unit due to certain sales objectives that had not been met. The Company will continue to make further personnel changes as it focuses on finding personnel with the product and market knowledge to successfully grow its wholesale business unit. 45 Furthermore, late in the third fiscal quarter, the Company restructured its operations and consolidated certain functions resulting in the layoff of certain personnel which will result in a monthly savings of approximately $50,000 going forward. Until sales and profits in the wholesale business improve, the Company will continue to make cost reductions in all areas so that it can meet its business operating requirements and service its debt obligations. Throughout the remainder of fiscal year 2013, the Company will monitor its cellular operations to preserve its profitability in spite of the anticipated continuing declining revenues, focus on expanding its wholesale operations and will also begin to consider the viability of acquiring a complimentary business since the Company's senior debt and sales tax obligations have been resolved. With a new Board of Directors that has diverse business knowledge and potential access to key resources, the Company is anticipating more assistance developing its business strategies to increase the Company's profitability in the fourth fiscal quarter and into fiscal year 2014. Discontinued Operations-Sale of Two-Way Radio and Public Safety Equipment Business In June 2012, the Company concluded that its long standing two-way business was no longer aligned with the Company's strategic growth plans and therefore made a decision to sell this business. The Company also needed to make certain payments against its debt obligations with Thermo Credit which were negotiated in Waiver and Amendment No. 5 to the Loan and Security Agreement in February 2012. Although the Company had been successful growing the revenues of this business primarily through the sales of public safety equipment under its federal and state contracts, the profit margins on these additional sales were not sufficient to offset the direct costs of operating this business unit. In addition, the recent expansion of activities in this business unit had also put additional demands on corporate resources, both working capital and personnel resources, which were detracting from the Company's focus on transitioning to become a large scale wholesale distributor of cellular and car audio equipment. During fiscal 2012, the two-way business represented approximately 29% of the Company's operating revenues and had grown its revenues by approximately 109% from the prior fiscal year. However, the two-way business generated operating losses in both fiscal years 2011 and 2012. With the Company's strategic focus on growing its wholesale business and the limited remaining resources available to allocate to managing the two-way business to profitability, it was concluded that it was in the Company's best interest to sell this business. On August 11, 2012, the Company and DFW Communications, Inc. ("DFW"), a local competitor to Teletouch in the Dallas / Fort Worth, TX MSA, entered into an Asset Purchase Agreement ("APA"), whereby DFW took and acquired possession of substantially all of the assets associated with the two-way radio and public safety equipment business, such assets including, among other things, certain related accounts receivable; inventory; fixed assets (e.g. fixtures, equipment, machinery, appliances, etc.); supplies used in connection with the business; the Company's leases, permits and titles and certain FCC licenses held by the Company (see Note 3 - "Discontinued Two-Way Operations" for additional information on the sale of the two-way business). DFW also assumed certain obligations, permits and contracts related to the Company's business. Subject to certain working capital adjustments, DFW agreed to pay, at closing, as consideration for the assets of the Company an amount in cash equal to approximately $1,469,000, $168,000 of which is allocated to certain designated suppliers' payments and $300,000 of which is allocated to real estate and goodwill. The parties to the APA further designated approximately $767,000 for working capital to be allocated to the purchase of such amount consisting of, among other things, accounts receivable and inventory as of the effective date of the APA. The APA includes a working capital adjustment provision that provides for no more than $200,000 of post-close working capital adjustments to be charged to the Company in the event of any material accounts receivable or inventory deficits. As of February 28, 2013, the Company recorded an approximately $29,000 working capital chargeback due to the non-collection of certain outstanding accounts receivables which were sold to DFW under the APA. 46 The foregoing disposition of the Company's assets, excluding the sale of the real estate, closed on August 14, 2012, having been reviewed and approved by the Company's Board of Directors on August 10, 2012. On the August 14, 2012 closing, the Company received approximately $1,169,000 in cash consideration from DFW for all of the assets of the two-way radio and public safety equipment business, excluding the building and land located in Tyler, Texas, which required an environmental study prior to its sale. The proceeds were used by the Company to pay down its debt with Thermo and settle certain accounts payable related to the business. On February 26, 2013, the Company received proceeds of approximately $297,000 from the sale of its real estate in Tyler, Texas. The proceeds were subsequently used to pay down the Company's debt with Thermo. Discussion of Business Strategy by Operating Segment Cellular Operations Since the expiration of the Company's largest distribution agreement with AT&T, which included the Dallas / Fort Worth, Texas MSA in August 2009 and the subsequent arbitration proceeding against AT&T, the Company has concentrated on servicing its existing subscriber base and minimizing subscriber attrition. Following the execution of the Settlement and Release Agreement with AT&T on November 23, 2011 (the "AT&T Settlement"), the Company planned to expand its business with AT&T as an Authorized Service Provider and Exclusive Dealer. Under the Agreement, AT&T amended and renewed a 3 year distribution agreement for the Company's current and prior market areas, executed a new 6 year Exclusive Dealer agreement which runs co-terminously with the distribution agreement for the first 3 years and gave PCI the right and authorization to sell, activate and provide services to Apple iPhone and iPad models, both as an exclusive AT&T Distributor and Dealer. As a result of the AT&T Settlement, the Company began to focus its efforts on increasing its cellular subscriber base, in order to generate greater profits from its recurring revenue cellular billings. Given the increasing cost of cellular handsets, particularly the iPhone, the Company, has limited the total number of upgrades and new activations since the Company subsidizes a significant portion of the customer's cost of the phone. Through the third quarter of fiscal year 2012, the Company absorbed 100% of the required subsidy on the iPhone and a significant portion of the subsidy on other phone models, but beginning in April 2012, AT&T supplemented the distribution agreement and agreed to reimburse the Company for almost half of the required subsidy on the iPhone. Although this program is subject to change, the subsidy reimbursement on the number of iPhones sold by the Company from April 2012 through February 28, 2013 has been approximately $533,000. Additionally, subscriber attrition has remained at a higher level than originally forecast as subscribers continue to transfer service to AT&T for various reasons, including more access to AT&T-owned and agent locations in the markets where we operate today, and the greater product selection such outlets provide. Ultimately, without the ability to advertise the Company's brand message adequately, many customers and prospective customers remain unaware of the products we do have, the services we provide, or the relatively limited number of destination outlets in our markets. The combination of lower than expected activations and higher than expected customer attrition has caused the Company's cellular subscriber base and related revenues to continue to decline. In fiscal year 2013 and through the expiration of the distribution agreement in November 2014, the Company will closely monitor the number of subscribers remaining in its cellular subscriber base and will continue to focus on increasing the number of subscribers added to its subscriber base to maximize the transfer fees negotiated as part of the AT&T Settlement that will be paid to the Company through the expiration of distribution agreement. As of February 28, 2013, the Company has earned approximately $670,000 in transfer fees from AT&T related to approximately 4,500 subscribers that transferred their service from PCI to AT&T following the November 2011 settlement with AT&T. In addition, the Company will continue to monitor the overhead expenses related to its cellular operations. After analyzing the profit margins and customer statistics related to each Hawk retail store, the Company closed four under-performing stores in June 2012 and reduced the hours of operations for the remaining retail stores. Additionally, and as result of this review, several of the remaining retail stores were identified as having excess space or too high of operating cost. The Company is currently considering relocating certain stores to smaller retail locations and estimates that by doing so it could realize up to an additional $100,000 in cost savings annually. 47 Wholesale Business Beginning in fiscal 2010 and continuing into fiscal 2011, the Company increased its cellular handset brokerage business by selling to volume buyers both domestically and internationally. Initially the Company primarily brokered phones manufactured by Research In Motion, as the manufacturer of Blackberry® cellular handsets. This brokerage business significantly contributed to the product sales for the Company's wholesale business beginning in fiscal year 2010 and continuing through November 30, 2011. After the Company entered into the settlement agreement with AT&T in November 2011, the Company was no longer allowed to sell AT&T-branded cellular phones to customers that are not subscribers of AT&T cellular services, with the exception that the Company is allowed to sell a relatively small amount of overstocked or obsolete handsets to other customers. In June 2012, the Company secured a multi-year national distribution agreement with TCT Mobile Multinational, Limited, a major international handset manufacturer, to sell Alcatel One Touch branded handsets. Additionally, in September 2012, the Company entered into a comprehensive distribution agreement with Unimax Communications, Inc., a subsidiary of Hong Kong-based telecom electronics manufacturer, Unimax Communications Corporation, to sell and distribute their UMX® branded mobile handsets. The Company has been anticipating the completion of these types of distribution agreements and was expecting substantial growth in the wholesale operations due to the sale of the Alcatel and Unimax handsets to Tier-2 and Tier-3 wireless carriers or operators in the United States by the end of the second fiscal quarter of 2013. To date, the Company has not experienced the sales and profits from these distribution agreements as expected. In the third fiscal quarter, the Company terminated its distribution agreement with Alcatel primarily due to the lack of product information and support from the manufacturer to sell the Alcatel handsets the Company ordered. Beginning in the second fiscal quarter, the Company began receiving orders for a limited quantity of Unimax handsets and began fulfilling those orders in the third fiscal quarter but manufacturing delays has constrained the potential for additional sales of the Unimax handsets. The Company is currently working with several Tier-2 and Tier-3 cellular carriers and has provided evaluation Unimax handsets to ensure the handsets will work on the carriers' respective networks. Many of the carriers have expressed an interest in a couple of different Unimax handset models and the Company anticipates receiving more handset orders and improved availability of these handsets in the fourth fiscal quarter. Although the Company has executed a number of distributor agreements with cellular accessory and car audio manufacturers such as AFC Trident, Inc., Cerwin Vega and Cadence, to name a few, the Company has not generated the additional sales revenue and profits to help improve the Company's overall operating performance. To date, the Company has not been effective in introducing a product line to the market with the appropriate pricing structures in place to maximize profits. The Company can attribute a portion of the sales deficiencies to the lack of market pricing enforcement, territory and customer restrictions by the product's manufacturers. As a result, the Company modified its distribution agreement with AFC Trident, Inc. ("Trident") in the third fiscal quarter due to infringements upon the Company's exclusive Authorized Master Distribution Agreement related to certain customer exclusivity rights. The Company entered into settlement agreement with Trident on February 28, 2013 due to alleged violations of the distribution agreement. Under the terms of the settlement agreement, Trident agreed to (i) $150,000 cash payable in three installments, (ii) a one-time reduction of approximately $11,000 related to the Company's outstanding balance to Trident and (iii) an authorization to return $50,000 of slow-moving Trident inventory. The Company is currently evaluating all of its wholesale product lines to determine which products to focus on that will improve sales and profitability the most quickly. The Company continues to evaluate new product lines for integration with existing product lines but is currently focused on eliminating any unsuccessful product lines and liquidating any remaining inventory related to those product lines. It is imperative for the Company to have key personnel with experience and knowledge of the wholesale business and the various market opportunities to achieve any substantial growth. The Company is currently reviewing the organizational structure of its wholesale business to ensure it has sufficient and proper resources to achieve its targeted sales objectives. 48 Results of Operations for the three and nine months ended February 28, 2013 and February 29, 2012 Overview of Operating Results for Three and nine Months ended February 28, 2013 and February 29, 2012 The consolidated operating results for the three and nine months ended February 28, 2013 and February 29, 2012, are as follows: (dollars in thousands) February 28, February 29, 2013 vs 2012 2013 2012 $ Change % Change Three Months Ended Operating results Service revenue $ 3,207 $ 3,620 $ (413 ) -11 % Product sales revenue 1,510 1,646 (136 ) -8 %Total operating revenues 4,717 5,266 (549 ) -10 % Cost of service (exclusive of depreciation and amortization) 645 943 (298 ) -32 % Cost of products sold 1,608 1,848 (240 ) -13 % Other operating expenses 2,457 3,219 (762 ) -24 % Texas sales and use audit assessment - 1,850 (1,850 ) -100 % Gain on settlement with AT&T (120 ) (168 ) 48 -29 % Gain on settlement with Trident (161 ) - (161 ) 100 % Operating income (loss) from continuing opertaions $ 288 $ (2,426 ) $ 2,714 112 % Net loss from continuing opertaions $ (187 ) $ (2,886 ) $ 2,699 -94 % Adjusted operating income (loss) from continuing operations and adjusted net loss from continuing operations reconciliation: Operating income (loss) from continuing operations $ 288 $ (2,426 ) $ 2,714 112 % Adjustments: Texas sales and use tax audit accrual 10 2,147 (2,137 ) -99 % Adjusted operating income (loss) from continuing operations $ 298 $ (279 ) $ 577 207 % Net loss from continuing operations $ (187 ) $ (2,886 ) $ 2,699 -94 % Adjustments: $ - Texas sales and use tax audit accrual 10 2,147 (2,137 ) -99 % Adjusted net loss from continuing operations $ (177 ) $ (739 ) $ 562 -76 % 49 (dollars in thousands) February 28, February 29, 2013 vs 2012 2013 2012 $ Change % Change Nine Months Ended Operating results Service revenue $ 10,341 $ 11,598 $ (1,257 ) -11 % Product sales revenue 4,599 7,428 (2,829 ) -38 % Total operating revenues 14,940 19,026 (4,086 ) -21 % Cost of service (exclusive of depreciation and amortization) 1,985 2,888 (903 ) -31 % Cost of products sold 4,762 7,615 (2,853 ) -37 % Other operating expenses 8,029 10,982 (2,953 ) -27 % Texas sales and use audit assessment - 1,850 (1,850 ) -100 % Gain on settlement with AT&T (397 ) (10,168 ) 9,771 -96 % Gain on settlement with Trident (161 ) - (161 ) 100 % Operating income from continuing operations $ 722 $ 5,859 $ (5,137 ) -88 % Net income (loss) from continuing operations $ (674 ) $ 4,215 $ (4,889 ) -116 % Adjusted operating income (loss) from continuing operations and adjusted net loss from continuing operations reconciliation: Operating income from continuing operations $ 722 $ 5,859 $ (5,137 ) -88 % Adjustments: Gain on settlement with AT&T - (10,000 ) 10,000 -100 % Management bonuses related to settlement with AT&T - 1,400 (1,400 ) -100 % Texas sales and use tax audit accrual 74 2,147 (2,073 ) -97 % Adjusted operating income (loss) from continuing operations $ 796 $ (594 ) $ 1,390 234 % Net income (loss) from continuing operations $ (674 ) $ 4,215 $ (4,889 ) -116 % Adjustments: Gain on settlement with AT&T - (10,000 ) 10,000 -100 % Management bonuses related to settlement with AT&T - 1,400 (1,400 ) -100 % Texas sales and use tax audit accrual 74 2,147 (2,073 ) -97 % Adjusted net loss from continuing operations $ (600 ) $ (2,238 ) $ 1,638 -73 % The Company reported operating income from continuing operations for the three months ended February 28, 2013 compared to an operating loss in the same period in the prior fiscal year primarily due to the Company recording an initial accrual of approximately $2,147,000 related to PCI's Texas sales and use audit issues in three months ended February 29, 2012 (see Note 10 - "Accrued Expenses and Other Current Liabilities and Note 10 - "Texas Sales and Use Tax Obligation" for more information on PCI's sales and use tax audit issues). The $288,000 operating income is comparable to the prior year's third fiscal quarter by adjusting out the $2,147,000 sales tax accrual, leaving an adjusted operating loss in the third fiscal quarter of 2012 of $279,000. As compared to this adjusted operating loss of $279,000, the Company improved its operating income in the current fiscal quarter by approximately $577,000. Operating income from the Company's cellular business improved by approximately $111,000 primarily due to the implementation of price increases in the fourth quarter of fiscal year 2012, the reimbursement of cellular handset costs from AT&T and cost savings from the closing of four Hawk stores in June 2012. These actions helped to offset the lost revenues from the Company's declining subscriber base. From February 29, 2012 to February 28, 2013, the subscriber base decreased by 7,831 subscribers. Additionally, the Company recorded a gain on the settlement with AFC Trident, Inc., a cellular accessory manufacturer and vendor to the Company, on February 28, 2013 of approximately $161,000 due to certain alleged violations of the Company's exclusive distribution agreement with AFC Trident, Inc. Also, the Company experienced a decrease in legal fees and billboard expenses of approximately $64,000 and $54,000 for the three months ended February 28, 2012, respectively compared to the prior fiscal year period. The decrease in legal fees is due to the Company completing its litigation against AT&T in November 2011 and billboard advertising expenses decreased due to the Company's decision to limit its use of billboard campaigns beginning in the fourth quarter offiscal year 2012. 50 The improvements in operating income during the third quarter of fiscal year 2013 discussed above were partially offset by an increase of approximately $129,000 in operating losses generated by the Company's wholesale business as compared to the same period in the prior fiscal year primarily due an increase in personnel costs associated with hiring a wholesale director and additional salespeople during the first and second quarters of fiscal year 2013. The Company reported a net loss from continuing operations for the nine months ended February 28, 2013 compared to net income in the same period in the prior fiscal year primarily due to the Company's successful litigation against AT&T in November 2011. The Company recorded a $10,000,000 gain offset by approximately $1,400,000 in other operating expenses related to management bonuses awarded as a result of the settlement with AT&T in the nine months ended February 29, 2012. Although the Company reported a decline in income for the current year-to-date period, its underlying continuing operations improved by approximately $1,638,000 when compared to an adjusted net loss from continuing operations of approximately $2,238,000 in the same period in the prior fiscal year, after excluding the $8,600,000 net gain ($10,000,000 gain on settlement less $1,400,000 in management bonuses) and the sales tax audit accrual of approximately $2,147,000 that was recorded in the nine months ended February 29, 2012. The cellular operation's earnings improved by approximately $68,000 for the nine months ended February 28, 2013 compared to the same period in the prior fiscal year primarily due to closing four Hawk retail stores in the first fiscal quarter of 2013 and the decrease of legal fees and billboard advertising expenses as well as a decrease in stock compensation expenses. Although the Company's cellular subscriber base declined year over year, the implementation of price increases in the fourth quarter of fiscal year 2012, the reimbursement of cellular handset costs from AT&T and cost savings from the closing of four Hawk stores in June 2012 helped offset the lost revenues from the Company's declining subscriber base. Additionally, the Company experienced a decrease in legal fees of approximately $441,000 for the current fiscal year-to-date period compared to the same period in the prior fiscal year primarily due to completing its litigation against AT&T in November 2011. Stock compensation expense also declined by approximately $123,000 for the nine months ended February 28, 2013 compared to the same period in the prior fiscal year due to the lower value of stock options granted to the Company's executive management and Board of Directors. Furthermore, the Company's decision to limit its billboard advertising campaigns in the fourth quarter of fiscal year 2012 reduced billboard expenses by approximately $170,000 in current fiscal year period compared to the same period in the prior fiscal year. The Company's wholesale business experienced an increase in operating losses of approximately $520,000 for current fiscal year-to-date period compared to the same period in the prior fiscal year. The increase in operating losses is directly related to the decrease in sales, which is primarily due to the fact the Company can no longer broker AT&T branded cellular handsets due to the execution of the settlement agreement with AT&T in November 2011. The nine months ended February 29, 2012 had approximately $2,532,000 in wholesale brokerage sales with no similar occurring transactions in the nine months ended February 28, 2013. In addition, personnel costs related to the wholesale business increased in the current fiscal year period compared to the same period in the prior fiscal year which is attributable to hiring a wholesale director and additional salespeople in the first and second quarters of fiscal year 2013. Significant Components of Operating Revenues and Expenses Operating revenues are primarily generated from the Company's cellular and wholesale operations and are comprised of a mix of service and product revenues. Service revenues are generated primarily from the Company's cellular operations. Within the cellular operations, the primary service revenues are generated by PCI from the sale of recurring cellular subscription services under several distributor agreements with AT&T. Since 1984, the Company's subsidiary, PCI, has held agreements with AT&T and its predecessor companies, which allowed PCI to offer cellular service and customer service to AT&T customers in exchange for certain compensation and fees. PCI is responsible for the billing and collection of cellular charges from these customers and remits a percentage of the cellular billings generated to AT&T. 51 The majority of the Company's product sales is generated by PCI's wholesale operations and is comprised of cellular telephones, cellular accessories and car audio and related electronics, which are sold to smaller dealers and carriers throughout the United States. Within the cellular operations of the Company, product sales are comprised primarily of cellular telephones and accessories sold through PCI's retail stores, outside salespeople and agents to generate recurring cellular subscription revenues. Cost of providing service consists primarily of costs related to supporting PCI's cellular subscriber base under the master distributor agreement with AT&T including: § Costs of recurring revenue features that are added to the cellular subscribers' accounts by PCI which are not subject to the revenue sharing arrangement with AT&T; such features include roadside and emergency assistance program, handset and accessory warranty programs and certain custom billing services. § Prior to the November 2011 settlement with AT&T, the cost of third-party roaming charges were passed through to PCI by AT&T and included in the cost of service and installation. Roaming charges are incurred when a cellular subscriber leaves the designated calling area and utilizes a carrier, other than AT&T, to complete the cellular call. PCI was charged by AT&T for 100% of these "off-network" roaming charges incurred by its customer base. Under the Third Amendment to Distribution Agreement with AT&T, which resulted from the November 2011 litigation settlement, roaming costs will be billed by PCI and subject to the revenue shared with AT&T effective with December 2011 billing cycle. § Costs to operate and maintain PCI's customer service department and call center to provide billing support and facilitate account changes for cellular service subscribers. These costs primarily include the related personnel costs as well as telecommunication charges for inbound toll-free numbers and outbound long distance. § Costs of the Company's retail stores including personnel, rents and utilities. § Costs of bad debt related to the cellular service billings. Cost of products sold consists of the net book value of items sold including cellular telephones, accessories, and 12-volt mobile electronics and their related accessories as well as any necessary write-downs of inventory for shrinkage and obsolescence. We recognize cost of products sold, other than costs related to write-downs of inventory, when title passes to the customer. In PCI's wholesale operations, products and accessories are sold to customers at pricing above PCI's cost. However, PCI will generally sell cellular telephones below cost to new and existing cellular service customers as an inducement to enter into two-year subscription contracts, to upgrade service and extend existing subscription contracts or in connection with other promotions. The resulting equipment subsidy to the majority of PCI's cellular customers is consistent with the cellular industry and is treated as an acquisition cost of the related recurring cellular subscription revenues. This acquisition cost is expensed by the Company when the cellular equipment is sold with the expectation that the subsidy will be recovered through margins on the cellular subscription revenues over the contract term with the customer. Selling and general and administrative costs include customer acquisition or selling costs, including the costs of our retail stores, sales commissions paid to internal salespeople and agents, payroll costs associated with our retail and direct sales force and marketing expenses. Also included in this category are the general and administrative corporate overhead costs including, billing and collections costs, information technology operations, customer retention, legal, executive management, finance, marketing, human resources, strategic planning, technology and product development, along with the related payroll and facilities costs. Other general and administrative costs included in this category are the ongoing costs of maintaining Teletouch as a public company, which include audit, legal and other professional and regulatory fees. 52 Service Revenue for the Three and nine Months ended February 28, 2013 and February 29, 2012 The service revenues shown below have been grouped and are discussed by the Company's reportable operating segments as defined under GAAP. (dollars in thousands) February 28, February 29, 2013 vs 2012 2013 2012 $ Change % Change Three Months Ended Service revenue Cellular operations Gross cellular subscription billings $ 6,509 $ 7,645 $ (1,136 ) -15 % Net revenue adjustment (revenue share due AT&T) (3,302 ) (4,025 ) 723 -18 % Cellular operations total service revenues: $ 3,207 $ 3,620 $ (413 ) -11 % Nine Months Ended Service revenue Cellular operations Gross cellular subscription billings $ 20,754 $ 24,368 $ (3,614 ) -15 % Net revenue adjustment (revenue share due AT&T) (10,413 ) (12,774 ) 2,361 -18 % Cellular operations total service revenues: 10,341 11,594 (1,253 ) -11 % Wholesale operations - 4 (4 ) -100 % Service revenue $ 10,341 $ 11,598 $ (1,257 ) -11 % Gross cellular subscription billings are measured as the total recurring monthly cellular service charges invoiced to PCI's cellular subscribers from which a fixed percentage of the dollars invoiced are retained by PCI as compensation for the billing and support services it provides to these subscribers. PCI remits a fixed percentage of the gross cellular subscription billings to AT&T and absorbs 100% of any bad debt associated with the gross cellular subscription billings under the terms of its distribution agreement with AT&T. The Company uses the calculation of gross cellular subscription billings to measure the overall growth of its cellular business and to project its future cash receipts from the subscriber base. The decrease in the gross cellular subscription billings for the three months and nine months ended February 28, 2013 compared to the same periods in the prior fiscal year is primarily due to a continued decline in cellular subscribers. The Company had 31,595 subscribers as of February 29, 2013 compared to 39,426 subscribers as of February 28, 2012. The changes in the components of gross cellular subscription billing charges for the three and nine months ended February 28, 2013 compared to the same periods in the prior fiscal year are as follows: 53 (dollars in thousands) February 28, February 29, 2013 vs 2012 2013 2012 $ Change % Change Three Months Ended Gross cellular subscription billing charges: Access charges (a) 1,831 2,494 (663 ) -27 % Data charges (b) 2,119 2,234 (115 ) -5 % PCI custom features (c) 1,554 1,579 (25 ) -2 % AT&T custom features (d) 545 690 (145 ) -21 % Roamer and toll charges (e) 144 223 (79 ) -35 % Government accessments 195 245 (50 ) -20 % Penatly charges (f) 162 154 8 5 % Other charges (41 ) 26 (67 ) -258 % Total gross cellular subscription billings $ 6,509 $ 7,645 $ (1,136 ) -15 % Nine Months Ended Gross cellular subscription billing charges: Access charges (a) 5,938 8,145 (2,207 ) -27 % Data charges (b) 6,483 6,776 (293 ) -4 % PCI custom features (c) 4,942 5,023 (81 ) -2 % AT&T custom features (d) 1,696 2,238 (542 ) -24 % Roamer and toll charges (e) 513 742 (229 ) -31 % Government accessments 604 797 (193 ) -24 % Penatly charges (f) 546 545 1 0 % Other charges 32 102 (70 ) -69 % Total gross cellular subscription billings $ 20,754 $ 24,368 $ (3,614 ) -15 % (a) Cellular voice plans (b) Cellular data plans and usage (c) Services including handset insurance, roadside assistance, accessory warranty programs, custom billing and other fees (d) AT&T features, including family talk, navigation and location based services, ringtone and game downloads and other fees (e) Roamer and long distance toll usage charges (f) Late fees and early contract termination charges Cost of Service for the Three and Nine Months ended February 28, 2013 and February 29, 2012 Cost of service expense consists of the following significant expense items: (dollars in thousands) February 28, February 29, 2013 vs 2012 2013 2012 $ Change % Change Three Months Ended Cost of service Cellular operations $ 645 $ 943 $ (298 ) -32 % Nine Months Ended Cost of service Cellular operations $ 1,981 $ 2,862 $ (881 ) -31 % Wholesale operations 4 26 (22 ) -85 % Total cost of service $ 1,985 $ 2,888 $ (903 ) -31 % The decrease in cost of service related to the Company's cellular operations for the three and nine months ended February 28, 2013 compared to the same periods in the prior fiscal year is partially related to the decrease in cellular service revenues, which is a direct result of the Company's declining cellular subscriber base. In addition, the cellular operation's personnel expense, bad debt expense and costs related to the Company's extended phone warranty program decreased by approximately $198,000, $46,000 and $41,000, respectively for the three months ending February 28, 2013 compared to the same period in the prior fiscal year. For the nine months ending February 28, 2013 compared to the same period from the prior fiscal year, the cellular operation's personnel expense, bad debt expense and costs related to the Company's extended phone warranty program decreased by approximately $570,000, $142,000 and $101,000, respectively. 54 Product Sales and Cost of Products Sold for the Three and Nine Months ended February 28, 2013 and February 29, 2012 Product sales and related cost of products sold shown below have been grouped and are discussed by the Company's reportable operating segments as defined under GAAP. (dollars in thousands) February 28, February 29, 2013 vs 2012 2013 2012 $ Change % Change Three Months Ended Product Sales Revenue Cellular $ 455 $ 589 $ (134 ) -23 % Wholesale 1,055 1,057 (2 ) 0 % Total product sales revenue $ 1,510 $ 1,646 $ (136 ) -8 % Cost of products sold Cellular $ 694 948 (254 ) -27 % Wholesale 914 900 14 2 % Cost of products sold $ 1,608 $ 1,848 $ (240 ) -13 % Nine Months Ended Product Sales Revenue Cellular $ 1,446 $ 1,532 $ (86 ) -6 % Wholesale 3,153 5,896 (2,743 ) -47 % Total product sales revenue $ 4,599 $ 7,428 $ (2,829 ) -38 % Cost of products sold Cellular $ 2,015 2,426 (411 ) -17 % Wholesale 2,747 5,189 (2,442 ) -47 % Cost of products sold $ 4,762 $ 7,615 $ (2,853 ) -37 % Product sales revenue: The decrease in product sales from the Company's wholesale operations for the nine months ended February 28, 2013 compared to the same period in the prior fiscal year is primarily due to a decrease in cellular handset brokerage sales. The Company recorded approximately $2,532,000 in wholesale brokerage sales for the nine months ended February 29, 2012, with no similar occurring transactions in the nine months ended February 28, 2013, which is a direct result of the settlement agreement with AT&T. Under the terms of the settlement with AT&T in November 2011, the Company is no longer allowed to broker AT&T branded cellular handsets. To help offset the loss of the brokerage sales, the Company has acquired several exclusive cellular handset, cellular accessory and car audio distribution agreements in fiscal year 2013.The Company is currently focusing on finding the right product mix and pricing structures to generate the additional profits that are needed to help offset the Company's declining cellular business while expanding the Company's wholesale business. Cost of products sold: The decrease in cost of products sold related to the Company's cellular business for the three and nine months ended February 28, 2013 compared to the same period in the prior fiscal year is a direct result of fewer cellular product sales due to the Company's declining cellular subscriber base. Cost of products sold in the cellular business decreased at a higher rate than product revenues due to AT&T reimbursing the Company for a portion of the handset subsidy beginning April 2012, including almost half of the subsidy on the iPhone. Under this program, the Company was reimbursed approximately $368,000 and $993,000 from AT&T during the three and nine months ending February 28, 2013, respectively. The Company is required to subsidize a substantial portion of the cost of cellular handsets sold in conjunction with a new service activation or renewal of a service contract in order to remain competitive with other cellular providers, including AT&T. Due to this, the Company has been forced to tighten its policies for approving the issuance of a subsidized handset to new and existing customers. The full cost of the cellular handset, including the portion that is subsidized by the Company, is expensed by the Company when the phone is activated and sold net of any reimbursement received from AT&T. Because the Company retains less than half of the gross cellular services it bills under the terms of its revenue sharing arrangement with AT&T, the payback period, or period that it takes the Company to recover the subsidy on the handset and achieve profitability on a particular subscriber, is much longer than AT&T or other carriers. Because cellular handset costs have continued to increase and the related subsidies offered by the carriers continue to increase, particularly related to the iPhone, in some instances the Company is finding that it cannot recover the handset subsidy over the standard 2 year subscriber contract term. 55 The decrease in cost of products sold attributable to the Company's wholesale operations for the nine months ended February 28, 2013 compared to the same periods from the prior fiscal year is a direct result of the decrease in brokerage sales from the Company's wholesale business. Selling and General and Administrative Expenses for the Three and Nine Months ended February 28, 2013 and February 29, 2012 Selling and general and administrative expenses consist of the following significant expense items: (dollars in thousands) February 28, February 29, 2013 vs 2012 2013 2012 $ Change % Change Three Months Ended Selling and general and administrative Salaries and other personnel expense $ 1,438 $ 1,464 $ (26 ) -2 % Bonus expnese 3 57 (54 ) -95 % Office expense 329 374 (45 ) -12 % Advertising expense 24 116 (92 ) -79 % Professional fees 218 401 (183 ) -46 % Taxes and licenses fees 37 342 (305 ) -89 %Stock-based compensation expense 6 6 - 0 % Other expenses 242 280 (38 ) -14 % Total selling and general and administrative $ 2,297 $ 3,040 $ (743 ) -24 % Nine Months Ended Selling and general and administrative Salaries and other personnel expense $ 4,241 $ 4,243 $ (2 ) 0 % Bonus expense 7 1,503 (1,496 ) -100 % Office expense 1,057 1,149 (92 ) -8 % Advertising expense 98 281 (183 ) -65 % Professional fees 873 1,508 (635 ) -42 % Taxes and licenses fees 147 412 (265 ) -64 %Stock-based compensation expense 173 296 (123 ) -42 % Other expenses 798 799 (1 ) 0 % Total selling and general and administrative $ 7,394 $ 10,191 $ (2,797 ) -27 % The decrease in bonus expense for the three and nine months ending February 28, 2013 is due to executive and management bonuses related to the settlement of the litigation against AT&T in November 2011. The bonuses were approved by the Company's Board of Directors and totaled approximately $1,400,000. The majority of the bonuses were paid out in December 2011. The current fiscal year periods had no similar occurring expenses. 56 The decrease in advertising expense for the three and nine months ended February 28, 2013 compared to the same periods in the prior fiscal year is primarily related to a reduction in billboard advertising. Beginning in the first quarter of fiscal year 2013, the Company reduced the number of billboards it uses to advertise in the Dallas / Fort Worth area to approximately 3 billboards compared to using approximately 15 billboards during fiscal year 2012. The decrease in the quantity of billboards reduced advertising expense by approximately $54,000 and $170,000 for the three and nine months ended February 28, 2013, respectively compared to the same periods in the prior fiscal year. The decrease in professional fees for the three and nine months ended February 28, 2013 compared to the same periods in the prior fiscal year is primarily attributable to a decrease in legal expenses resulting from the settlement with AT&T in November 2011. Legal expenses decreased by approximately $63,000 and $441,000 for the three and nine months ended February 28, 2013, respectively compared to the three and nine months ended February 29, 2012. In addition, the Company had approximately $60,000 in legal costs related to the change in ownership of Teletouch that occurred in the first quarter of fiscal year 2012 with no similar occurring expenses in fiscal year 2013. The Company's consulting fees decreased by approximately $45,000 and $106,000 for the three and nine months ended February 28, 2013, respectively compared to the three and nine months ended February 29, 2012. The decrease in consulting fees was primarily attributable to PCI's Texas sales and use tax audit and financial advisement related to a possible acquisition that took place during fiscal year 2012. Additionally, fees related to investor relations decreased by approximately $62,000 and $90,000 for the three and nine months ended February 28, 2013, respectively compared to the same period in the prior fiscal year as a result of the Company not renewing certain public relations contracts. The decrease in taxes and license fees for the three and nine months ended February 28, 2013, compared to the same periods in the prior fiscal year is primarily related to the Company recording the initial sales tax accrual of approximately $297,000, including estimated penalties and interest, in February 2012 related to sales and use tax issues identified for the periods subsequent to PCI's completed audit period (i.e. November 1, 2009 through February 29, 2012). The sales and use tax issues that were identified during PCI's recently completed audit period (i.e. January 2006 through October 2009) were applied to certain retail and cellular subscription billings and certain purchasing processes for the period subsequent to the completed audit period to calculate an estimated tax accrual. During the three and nine months ended February 28, 2013, the Company recorded approximately $5,000 and $42,000, respectively of potential interest and penalties related to this sales tax contingency. The decrease in stock-based compensation expense for the nine months ended February 28, 2013 compared to the same period from the prior fiscal year is due to a decrease in the value of the options that were granted to the Company's executive management team and Board of Directors. During the first nine months of fiscal year 2013, the Company granted a total of 773,167 stock options with an approximate $0.20 fair value per option. The options granted were fully vested upon issuance. During the first nine months of fiscal year 2012, the Company granted 783,167 stock options with an approximate fair value per option that ranged from $0.30 to $0.46 to its executive management team and Board of Directors. All of these options were also fully vested upon issuance. 57 Other Operating Expenses for the Three and Nine Months Ended February 28, 2013 and February 29, 2012 (dollars in thousands) February 28, February 29, 2013 vs 2012 2013 2012 $ Change % Change Three Months Ended Other Operating Expenses Depreciation and amortization: Depreciation $ 51 $ 52 $ (1 ) -2 % Amortization 170 161 9 6 % Total depreciation and amortization $ 221 $ 213 $ 8 4 % Nine Months Ended Other Operating Expenses Depreciation and amortization: Depreciation $ 157 $ 158 $ (1 ) -1 % Amortization 510 667 (157 ) -24 % Total depreciation and amortization $ 667 $ 825 $ (158 ) -19 % The decrease in amortization expense for the nine months ended February 28, 2013 compared to the same periods in the prior fiscal year is attributable to loan origination fees related to the Company's revolving credit facility with Thermo and mortgage debt which were fully amortized by the end of fiscal year 2012. Gain on Settlement with AT&T for the Three and Nine Months ended February 28, 2013 and February 29, 2012 Due to the settlement and release agreement with AT&T that was executed on November 23, 2011, AT&T pays the Company for the cellular subscribers that transfer their service from PCI to AT&T. For the three and nine months ended February 28, 2013 and February 29, 2012, the Company recorded the fees it earned for those lost subscribers under the caption "Gain on the settlement with AT&T". Furthermore, the Company recorded the financial results related to the settlement with AT&T in November 2011 as a reduction to operating expenses under the caption "Gain on settlement with AT&T" on its consolidated income statements for the three and nine months ended February 29, 2012. The gain consisted of a cash award of $5,000,000 and a $5,000,000 forgiveness and discharge of the oldest accounts payable due to AT&T. Gain on Settlement with Vendor for the Three and Nine Months ended February 28, 2013 and February 29, 2012 During fiscal year 2013, the PCI was made aware of potential infringements upon its exclusive Authorized Master Distribution Agreement with AFC Trident, Inc. ("Trident"), a cellular accessory manufacturer and vendor to PCI, connected to certain customer exclusivity rights. As a result, the PCI entered into settlement agreement with Trident on February 28, 2013 related to certain alleged violations of the distribution agreement. Under the terms of the settlement agreement, Trident agreed to (i) $150,000 cash to be paid in three installments with the first payment due on February 28, 2013, the second payment due on March 30, 2013 and the third payment due on April 29, 2013; as of the date of this Report, the first and second payments totaling $100,000 has been received by the Company (ii) a one-time reduction of approximately $11,000 related to the PCI's outstanding balance to Trident and (iii) an authorization to return $50,000 of slow-moving Trident inventory. Additionally, in connection with the settlement agreement, PCI terminated its original distribution agreement and entered into non-exclusive distribution agreement with Trident. The $150,000 cash settlement and the $11,000 adjustment related to the balance owed to Trident are recorded under the caption "Gain on settlement with vendor" on the Company's consolidated income statement for the three and nine months ended February 28, 2013. 58 Interest Expense for the Three and Nine Months ended February 28, 2013 and February 29, 2012 Interest expense, net of interest income recorded against each of the Company's debt obligations is as follows: (dollars in thousands) February 28, February 29, 2013 vs 2012 2013 2012 $ Change % Change Three Months Ended Interest Expense DCP revolving credit facility 93 - 93 100 %Thermo revolving credit facility $ 239 $ 375 $ (136 ) -36 % Thermo subordinated note 16 - 16 100 % Real estate debt 60 37 23 62 %Warrant redemption notes payable - 4 (4 ) -100 % Other, net 11 1 10 1000 % Total interest expense, net $ 419 $ 417 $ 2 0 % Nine Months Ended Interest Expense DCP revolving credit facility 93 - 93 100 %Thermo revolving credit facility $ 908 $ 1,321 $ (413 ) -31 % Thermo subordinated note 16 - 16 100 % Real estate debt 148 111 37 33 %Warrant redemption notes payable - 32 (32 ) -100 % Other, net 32 3 29 967 % Total interest expense, net $ 1,197 $ 1,467 $ (270 ) -18 % The decrease in interest expense for the nine months ended February 28, 2013 compared to the same periods in the prior fiscal year is primarily attributable to a reduction in the amount of outstanding debt. Since February 2012, the Company has paid approximately $3,300,000 in principal payments, including forgiveness of certain commitment fees related to the modification of the Thermo loan. The increase in interest expense related the mortgage debt in the current fiscal year periods compared to the prior fiscal year periods is due to a rate change on the East West Bank debt effective November 2012. Income Tax Provision for the Three and Nine Months ended February 28, 2013 and February 29, 2012 The majority of the income tax expense recorded for the three and nine months ended February 28, 2013 and February 29, 2012 is related to the Texas margin tax, which was initially implemented by the State of Texas effective January 1, 2008. In the three months ended February 28, 2013 and February 29, 2012, the Company recorded approximately $61,000 and $41,000, respectively in state tax expenses. In the nine months ended February 28, 2013 and February 29, 2012, the Company recorded approximately $183,000 and $123,000, respectively in state tax expenses. The margin tax is calculated by using the Company's gross receipts from business conducted in Texas each fiscal year less a cost of goods sold deduction. The margin tax is due and payable to the State of Texas each year in May. In addition, the Company recorded a federal alternative minimum tax ("AMT") liability of approximately $36,000 and $65,000 in the nine months ended February 28, 2013 and February 29, 2012, respectively, due to the income generated from the financial results of the settlement with AT&T. The AMT tax rules do not allow the taxable income to be offset by the full amount of the Company's net operating losses. Alternative minimum taxes are due and payable to the Internal Revenue Service on a quarterly basis. 59 Financial Condition as of February 28, 2013 (dollars in thousands) Nine Months Ended February 28, February 29, 2013 vs 2012 2013 2012 $ Change % Change Cash provided by operating activities $ 121 $ 4,210 $ (4,089) -97 % Cash provided by (used in) investing activities 1,284 (239 ) 1,523 637 %Cash used in financing activities (2,622 ) (1,338 ) (1,284 ) 96 % Net increase (decrease) in cash $ (1,217 ) $ 2,633 $ (3,850 ) -146 % Liquidity and Capital Resources As of February 28, 2013, the Company had approximately $756,000 cash on hand and a working capital deficit of approximately $4,195,000 compared to a working capital deficit of approximately $11,662,000 as of May 31, 2012. The reduction of the working capital deficit is attributable to the settlement agreement the Company entered into with the State of Texas related to PCI's sales and use tax audit, closing on a new long-term credit facility with DCP Teletouch Lender, LLC ("DCP") and using the proceeds to pay down and amend the current debt that was payable to Thermo Credit, LLC ("Thermo") in the third quarter of fiscal year 2013 (see further discussion below). All of these events resulted in a reclassification of current debt to long-term debt and have improved the Company's financial condition by now having new or restructured debt obligations that the Company expects to be able to service with cash on hand and cash generated through operations for the foreseeable future. During the nine months ended February 28, 2013, the Company had sufficient cash to pay its trade payable obligations as they came due, make all scheduled principal and interest payments against its debt and continue its investment in inventory to support its business operations. Furthermore, in the nine months ended February 28, 2013, the Company paid approximately $83,000 related to its 2012 Texas margin tax obligation and $647,000 against PCI's Texas sales and use tax audit obligation. In February 2012, Thermo notified the Company it would cease advancing any additional funds to the Company under its revolving credit facility and needed to exit the debt facility as soon as possible. Following this notice, the Company immediately began focusing on securing new debt financing to replace its existing debt facility with Thermo. On August 1, 2012, the Company executed a term sheet with DCP and onFebruary 8, 2013, the Company entered into a Loan and Security Agreement (the "DCP Loan Agreement") with DCP (see "DCP Revolving Credit Facility" in Note 12 for additional discussion on the terms of this new credit facility). The loan is facilitated through an asset-based revolving credit facility. The primary purpose of this new credit facility with DCP was to refinance and pay down a portion of the Company's current indebtedness to Thermo under the terms of the April 30, 2008 Loan and Security Agreement by and between Teletouch, PCI and Thermo, as subsequently amended (the "Thermo Loan Agreement"). In order to facilitate the payment of the Company's indebtedness to Thermo under the Thermo Loan Agreement, the parties to the Loan Agreement also entered into several amendments, subordination and other related agreements. Specifically, Teletouch, PCI and Thermo entered a certain Sixth Amendment to the Thermo Loan Agreement ("Amendment No. 6"). In addition, the parties also entered into a certain Subordination and Intercreditor Agreement by and between Thermo and DCP dated as of February 8, 2013 (the "Subordination Agreement") for the purposes of subordinating Thermo's security interest to that of DCP under the DCP Loan Agreement (see "Thermo Revolving Credit Facility" in Note 12 for additional discussion on the restructuring of this debt). As a result of these financing and restructuring transactions, the Company was able to borrow $4,300,000 from DCP at closing, of which $4,000,000 was paid to Thermo against the outstanding balance of $7,148,000 owed against the Thermo Loan Agreement as of February 8, 2013. The remaining $3,148,000 due to Thermo became subordinated to DCP and is repayable under certain conditions as defined by the DCP Loan Agreement. If the now subordinated Thermo Loan Agreement is not repaid during the term the DCP Loan Agreement is outstanding, the remaining balance due to Thermo will be payable on August 1, 2016, which is six months following the January 31, 2016 maturity date of the optional extension under the DCP Loan Agreement. 60 As previously reported, in June 2012, the Company was assessed $1,880,000 by the State of Texas (the "State") related to a sales and use tax audit of PCI for covering the periods from January 2006 through October 2009. On January 7, 2013, the Company and the State of Texas entered into a settlement agreement related to PCI's sales and use tax audit obligation, whereby the Company agreed to settle its approximately $1,911,000 tax liability, which included penalties and interest assessed through January 3, 2013 of approximately $498,000, by making a series of payments to the State totaling approximately $1,414,000. Under the terms of the settlement agreement with the State, the Company was required to make a down payment against the sales tax liability of $625,000 on or before January 12, 2013 and make 35 monthly installments of $22,000 each beginning February 15, 2013, with a final payment of $18,888.10 due January 15, 2016. Prior to entering into this settlement agreement, the Company had voluntarily paid a total of $150,000 against this tax liability and the State allowed the Company to reduce its down payment by the full amount of the voluntary payments already made which resulted in the Company paying the $475,000 balance of the down payment in January 2013. The Company expects to be able to make these required payments to the State from cash provided by operations and has DCP's consent to make such payments as they become due. See Note 11 for additional discussion related to the settlement of this tax obligation. The Company has been advised by counsel that it can seek recovery of taxes that were not billed or collected from its customers and suppliers beginning in January 2006 and intends to make every reasonable effort to pursue the collection of such taxes. Based on a detailed review of all currently available cellular billings from August 2006 through October 2009, and a review of certain equipment sales invoices from January 2006 through October 2009, the Company has determined the total unbilled and uncollected sales tax is approximately $1,785,000 of the unbilled sales taxes that the Company will pursue for recovery. Invoices to current and former customers for these under-billed sales taxes are expected to be mailed during the fourth quarter of fiscal 2013. Under the terms of the DCP Loan Agreement, $400,000 was initially advanced to the Company as a supplemental advance and up to the first $400,000 collected from this sales tax recovery effort is required to be paid against this supplemental advance amount, with the balance of this supplemental advance to be paid down to $300,000 by May 9, 2013, $200,000 by June 8, 2013 and paid in full by July 8, 2013. The Company expects that sales tax recoveries will be sufficient to meet these repayment obligations to DCP as they come due or alternatively that it will have sufficient cash on hand to make these payments. There can be no assurance that the Company's recovery efforts will be successful, nor can the Company estimate an amount of recovery expected from such efforts at this time. The Company's real estate loans with East West Bank and Jardine Capital Corporation initially matured on May 3, 2012. Both lenders have granted several extensions of the maturity date of their respective loans. As of the date of this Report, Jardine Capital Corporation has granted an extension of the maturity date of their loan through May 31, 2013, but the East West Bank loan matured on February 3, 2013 and an extension is being discussed but has not been granted. With the completion of the senior debt restructuring and the settlement of the sales tax obligation, the Company is optimistic it will be successful in securing a commitment from a new lender to finance its real estate, if needed. The Company has placed the real estate for sale and is currently negotiating a term sheet with a prospective buyer. If the real estate is sold, the Company expects the proceeds to be sufficient to pay the balance due on all of its current real estate debt. Based on the current appraisal of the real estate received in March 2013, the Company is looking to improve its operating cash positions by drawing on the equity (excess fair value over current debt owed against the real estate) in all of the Company's real estate in Fort Worth, Texas (corporate office building on 6.0 acres, 6.93 acres of excess adjacent land and a free standing billboard on 0.08 acres of land) by selling the real estate (preferred option) or by refinancing the current debt. The Company can provide no assurance it will be successful in selling the real estate, securing new real estate financing or that East West Bank will be agreeable to extend the maturity date of their loan or that any further extensions from either mortgage lender will allow a sufficient amount of time for the Company to sell the real estate or close refinance the current debt before the current estate lenders take action against the Company and the underlying real estate collateral. 61 As a result of the completion of all of the above mentioned events during the third quarter of fiscal 2013, the Company has made significant progress toward improving its financial condition and believes that it has the ability to service its current debt obligations as they become due with the exception of the real estate loans as discussed above. If either real estate lender decides to foreclose on the Company's Fort Worth real estate, the Company believes that the fair market value of the properties sufficiently exceeds the amount of the debt and that the sale of these properties by either bank would extinguish all of the real estate debt. If this were to occur, the Company also believes that it has sufficient cash on hand and will generate sufficient cash from operations to support the relocation of the Company's Fort Worth offices and warehouse and the expected costs of leasing a new facility. The Company's estimates of cash provided from operations is based on the successful execution of the current business plan by achieving planned sales and margins from its wholesale business or through aggressive cost reductions to manage cash flows from its declining cellular business. The Company can provide no assurance that it will be successful achieving its planned sales growth or that it can reduce costs to a level to maintain the needed cash flows to meet all of its obligations. Operating Activities The decrease in cash provided by the operating activities for the nine months ended February 28, 2013 compared to the nine months ended February 29, 2012 is primarily due to the $5,000,000 cash payment the Company received on December 1, 2011 as a result of the settlement agreement with AT&T. Investing Activities The increase in cash provided by investing activities for the nine months ended February 28, 2013 compared to the nine months ended February 29, 2012 is primarily attributable to proceeds of approximately $1,466,000 the Company received from the sale of its two-way business. Financing Activities The increase in cash used in financing activities for the nine months ended February 28, 2013 compared to the nine months ended February 29, 2012 is primarily due to costs the Company incurred to close the Company's new senior credit facility with DCP Teletouch Lender, LLC. In addition, the portion of payments to the State of Texas made under the financing agreement (related to PCI's sales and use tax audit obligation) contributed to the increase of cash used in financing activities for the nine months ended February 28, 2013 compared to the same period in the prior fiscal year. Supplemental Cash Flow Data In the nine months ended February 28, 2013, the Company primarily paid interest related to its debt obligations which was required under its revolving credit facility with Thermo Credit, LLC and its real estate debt with East West Bank and Jardine Capital Corporation. In addition, during the nine months ended February 28, 2013, the Company made approximately $84,000 in franchise tax payments primarily related to the 2012 Texas Margin tax and approximately $127,000 in federal income tax payments attributable to the Alternative Minimum Tax that was due as a result of the Company recording net income in fiscalyear 2012. 62 Off-Balance Sheet Transactions The Company does not engage in off-balance sheet transactions. Critical Accounting Estimates The preceding discussion and analysis of financial condition and results of operations are based upon Teletouch's consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an on-going basis, Teletouch evaluates its estimates and assumptions, including but not limited to those related to the impairment of long-lived assets, reserves for doubtful accounts, provision for income taxes, revenue recognition and certain accrued liabilities. Teletouch bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Allowance for Doubtful Accounts: The Company performs credit evaluations of its customers prior to extending open credit terms. The Company does not perfect a security in any of the goods it sells causing all credit lines extended tobe unsecured. In determining the adequacy of the allowance for doubtful accounts, management considers a number of factors, including historical collections experience, aging of the receivable portfolio, financial condition of the customer and industry conditions. The Company considers accounts receivable past due when the customer's payment in full is not received within payment terms. The Company writes-off accounts receivable when it has exhausted all collection efforts, which is generally within 90 days following the last payment received on the account. Accounts receivable are presented net of an allowance for doubtful accounts of $142,000 and $150,000 at February 28, 2013, and May 31, 2012, respectively. Based on the information available, management believes the allowance for doubtful accounts as of those periods are adequate; however, actual write-offs may exceed the recorded allowance. The Company evaluates its write-offs on a monthly basis. The Company determines which accounts are uncollectible, and those balances are written-off against the Company's allowance for doubtful accounts. Reserve for Inventory Obsolescence:Inventories are stated at the lower of cost (on a moving average basis, which approximates actual cost determined on a first-in, first-out ("FIFO") basis), or fair market value and are comprised of finished goods. In determining the adequacy of the reserve for inventory obsolescence, management considers a number of factors including recent sales trends, age of the inventory, industry market conditions and economic conditions. In assessing the reserve, management also considers price protection amounts it expects to recover from certain vendors when the vendor reduces cost on certain items shortly after they are purchased by the Company. Additionally, management records specific valuation allowances for discontinued inventory based on its prior experience liquidating this type of inventory. Through the Company's wholesale and internet distribution channels, it has been successful liquidating the inventory that becomes obsolete at or near its cost basis if marketed soon after such obsolescence is determined. The Company has many different cellular accessory, radio and other electronics suppliers, all of which provide reasonable notification of model changes, which allows the Company to minimize its level of discontinued or obsolete inventory. Inventories are presented net of a reserve for obsolescence of approximately $186,000 and $155,000 at February 28, 2013, and May 31, 2012, respectively. Actual results could differ from those estimates. 63 Impairment of Long-Lived Assets: In accordance with ASC 360, Property, Plant and Equipment, ("ASC 360"), the Company evaluates the recoverability of the carrying value of its long-lived assets based on estimated undiscounted cash flows to be generated from such assets. If the undiscounted cash flows indicate an impairment, then the carrying value of the assets being evaluated is written-down to the estimated fair value of those assets. In assessing the recoverability of these assets, the Company must project estimated cash flows, which are based on various operating assumptions, such as average revenue per unit in service, disconnect rates, sales productivity ratios and expenses. Management develops these cash flow projections on a periodic basis and reviews the projections based on actual operating trends. The projections assume that general economic conditions will continue unchanged throughout the projection period and that their potential impact on capital spending and revenues will not fluctuate. Projected revenues are based on the Company's estimate of units in service and average revenue per unit as well as revenue from various new product initiatives. Projected revenues assume a continued decline in cellular service revenue while projected operating expenses are based upon historic experience and expected market conditions adjusted to reflect an expected decrease in expenses resulting from ongoing cost saving initiatives. The Company's review of the carrying value of its tangible long-lived assets at May 31, 2012 indicated the carrying value of these assets were recoverable through estimated future cash flows. Because of historical losses the Company has incurred, the Company also reviewed the market values of these assets. The review indicated the market value exceeded the carrying value at May 31, 2012. However, if the cash flow estimates or the significant operating assumptions upon which they are based change in the future, Teletouch may be required to record impairment charges related to its long-lived assets. The most significant tangible long-lived asset owned by the Company is its corporate office building and the associated land in Fort Worth, Texas. The Company has received periodic appraisals of the fair value of this property, with the most recent appraisal completed in March 2013, and in each instance the appraised value exceeds the carrying value of the property. The Company's review of the carrying value of its tangible long-lived assets at February 28, 2013 and May 31, 2012 indicates the carrying value of these assets will be recoverable through estimated future cash flows. If the cash flow estimates, or the significant operating assumptions upon which they are based change in the future, the Company may be required to record impairment charges related to its long-lived assets. In accordance with ASC 360, Teletouch evaluates the recoverability of the carrying value of its long-lived assets and certain intangible assets based on estimated undiscounted cash flows to be generated from such assets. The evaluation of the Company's long-lived intangible assets is discussed in Note 2 under "Intangible Assets." Under the same premise as the long-lived tangible assets, their market values were also evaluated at May 31, 2012, and the Company determined that based primarily on the market value and supported by the Company's cash flow projections, there was no impairment of these assets. If the cash flow estimates or the significant operating assumptions upon which they are based change in the future, Teletouch may be required to record impairment charges related to its long-lived assets. Impairment of Intangible Assets: The Company's intangible assets include both definite and indefinite lived assets. Indefinite lived intangible assets are not amortized but evaluated annually (or more frequently) for impairment under ASC 350, Intangibles-Goodwill and Other, ("ASC 350"). Definite lived intangible assets are amortized over the estimated useful life of the asset and reviewed for impairment upon any event that raises a question as to the asset's ultimate recoverability as prescribed under ASC 360, Property, Plant and Equipment,("ASC 360"). 64 The Company's indefinite lived intangible assets consist of two perpetual licenses purchased by PCI. In May 2010, PCI purchased a perpetual trademark license to use the trademark "Hawk Electronics" (see Note - 13 "Trademark Purchase Obligation" for additional discussion). Since it has been determined the trademark license has an indefinite useful life, the carrying value of the trademark license is not amortized over a specific period of time but instead is tested for impairment at least annually in accordance with the provisions of ASC 350. In January 2013, PCI entered into a Settlement and Patent License Agreement (the "GeoTag Agreement") with GeoTag, Inc. ("GeoTag") for the rights to use GeoTag's patented store locater tool on any of the Company's websites. PCI paid GeoTag $75,000 for the use of the perpetual patent license. In addition, the perpetual patent license is a royalty-free, non-exclusive license that PCI or any of its Affiliates (as defined in the GeoTag Agreement, but includes Teletouch) can use throughout the life of the GeoTag store locator patent. The Company evaluated the Hawk Electronics perpetual trademark license asset at May 31, 2012, in accordance with ASC 350 and determined the fair value of the license exceeded its carrying value; therefore, no impairment was recorded. The fair value of the perpetual trademark license was based upon the discounted estimated future cash flows of the Company's cellular business which is the primary beneficiary of the Hawk brand. Furthermore, the Company evaluates the GeoTag perpetual patent license in a manner similar to the Hawk Electronics perpetual trademark license by assessing whether events and circumstances have occurred within the Company's cellular business that would no longer support an indefinite life for either of the perpetual licenses. No changes have occurred in the business during the three or nine months ended February 28, 2013 that indicated impairment for either of the perpetual licenses. Definite lived intangible assets consist of the capitalized cost associated with acquiring the AT&T distribution agreement, purchased subscriber base, GSA contract, TXMAS contract and loan origination costs associated with acquiring the new asset based revolving credit facility. The Company does not capitalize customer acquisition costs in the normal course of business, but would capitalize the purchase costs of acquiring customers from a third party. Intangible assets are carried at cost less accumulated amortization. Amortization on the AT&T distribution agreement is computed using the straight-line method over the contract's remaining term through November 2014. The estimated useful lives for the intangible assets are as follows: AT&T distribution agreement and subscriber base 1-13 years GSA and TXMAS contracts 5 years Loan origination fees Term of loan The Company defers certain direct costs in obtaining loans and amortizes such amounts using the straight-line method over the expected life of the loan, which approximates the effective interest method. As of February 28, 2013, the most significant intangible assets owned by the Company are the AT&T distribution agreement and subscriber base. The AT&T cellular distribution agreement and subscriber base assets will be amortized through November 30, 2014, which is the expiration of the distribution agreement under the terms of the Third Amendment to the Distribution Agreement (see Note 5 - "Relationship With Cellular Carrier" for further discussion on the settlement of the litigation with AT&T and the resulting amended distribution agreement). Amortization expense over the 21 months remaining under the current term of the AT&T distribution agreement will be approximately $57,000 per month. 65 The AT&T distribution agreement asset represents a contract the Company has with AT&T, under which the Company is allowed to provide cellular services to its customers. The Company regularly forecasts the expected cash flows to be derived from the cellular subscriber base and the Company anticipates the future cash flows generated from its cellular subscriber base to exceed the carrying value of this asset. Amortization of the AT&T distribution agreement, subscriber base, GSA and TXMAS contracts is recorded as an operating expense under the caption "Depreciation and Amortization" in the accompanying consolidated statements of operations. Amortization of the loan origination fees is recorded under the caption "Interest expense" in the accompanying consolidated statements of operations. The Company periodically reviews the estimated useful lives of its intangible assets, taking into consideration any events or circumstances that might result in a lack of recoverability or revised useful life. Contingencies: The Company accounts for contingencies in accordance with ASC 450, Contingencies ("ASC 450"). ASC 450 requires that an estimated loss from a loss contingency shall be accrued when information available prior to issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and when the amount of the loss can be reasonably estimated. Accounting for contingencies such as legal and contract dispute matters requires us to use our judgment. We believe that our accruals or disclosures related to these matters are adequate. Nevertheless, the actual loss from a loss contingency might differ from our estimates. Provision for Income Taxes: The Company accounts for income taxes in accordance with ASC 740, Income Taxes, ("ASC 740") using the asset and liability approach, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of such assets and liabilities. This method utilizes enacted statutory tax rates in effect for the year in which the temporary differences are expected to reverse and gives immediate effect to changes in income tax rates upon enactment. Deferred tax assets are recognized, net of any valuation allowance, for temporary differences, net operating loss and tax credit carry forwards. Deferred income tax expense represents the change in net deferred assets and liability balances. Deferred income taxes result from temporary differences between the basis of assets and liabilities recognized for differences between the financial statement and tax basis thereon and for the expected future tax benefits to be derived from net operating losses and tax credit carry forwards. A valuation allowance is recorded when it is more likely than not that deferred tax assets will be unrealizable in future periods. As of February 28, 2013 and May 31, 2012, the Company has recorded a valuation allowance against the full amount of its net deferred tax assets. The Company will continue to evaluate its financial forecast to determine if a portion of its deferred tax assets can be realized in future periods. When the Company is charged interest or penalties related to income tax matters, the Company records such interest and penalties as interest expense in the consolidated statement of operations. The Company's most significant deferred tax asset is its accumulated net operating loss. These net operating loss is subject to limitations as a result of a change in control that took place during August 2011, as defined by Section 382 of the Internal Revenue Code. Revenue Recognition: Teletouch recognizes revenue over the period the service is performed in accordance with SEC Staff Accounting Bulletin No. 104, "Revenue Recognition in Financial Statements" and ASC 605, Revenue Recognition, ("ASC 605"). In general, ASC 605 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable, and (4) collectability is reasonably assured. Teletouch believes, relative to sales of products, that all of these conditions are met; therefore, product revenue is recognized at the time of shipment. 66 The Company primarily generates revenues by providing recurring cellular services and through product sales. Cellular services include cellular airtime and other recurring services provided through a distributor agreement with AT&T. Product sales include sales of cellular telephones, accessories, car audio products and other services through the Company's retail and wholesale operations. Cellular and other service revenues and related costs are recognized during the period in which the service is rendered. Associated subscriber acquisition costs are expensed as incurred. Product sales revenue is recognized at the time of shipment, when the customer takes title and assumes risk of loss, when terms are fixed and determinable and collectability is reasonably assured. The Company does not generally grant rights of return. However, to be competitive with AT&T's programs, PCI offers customers a 15 day return / exchange program for new cellular subscribers. During the 15 days, a customer may return all cellular equipment and cancel service with no penalty. Reserves for returns, price discounts and rebates are estimated using historical averages, open return requests and market conditions. No reserves have been recorded for the 15 day cellular return program since only a very small number of customers utilize this return program and many fail to meet all of the requirements of the program, which include returning the phone equipment in new condition with no visible damage. Since 1984, Teletouch's subsidiary, PCI, has held agreements with AT&T or one of its predecessor companies, which allowed PCI to offer cellular service and provide the billing and customer services to its subscribers. PCI is compensated for the services it provides based upon sharing a portion of the monthly billings of AT&T cellular services with AT&T. PCI is responsible for the billing and collection of cellular charges from these customers and remits a percentage of the cellular billings generated to AT&T. Based on its relationship with AT&T, the Company has evaluated its reporting of revenues under ASC 605-45, Revenue Recognition, Principal Agent Considerations ("ASC 605-45") associated with its services attached to the AT&T agreements. Included in ASC 605-45 are eight indicators that must be evaluated to support reporting gross revenue. These indicators are (i) the entity is the primary obligor in the arrangement, (ii) the entity has general inventory risk before customer order is placed or upon customer return, (iii) the entity has latitude in establishing price, (iv) the entity changes the product or performs part of the service, (v) the entity has discretion in supplier selection, (vi) the entity is involved in the determination of product or service specifications, (vii) the entity has physical loss inventory risk after customer order or during shipment and (viii) the entity has credit risk. In addition, ASC 605-45 includes three additional indicators that support reporting net revenue. These indicators are (i) the entity's supplier is the primary obligor in the arrangement, (ii) the amount the entity earns is fixed and (iii) the supplier has credit risk. Based on its assessment of the indicators listed in ASC 605-45, the Company has concluded that the AT&T services provided by PCI should be reported on a net basis. Also in accordance with ASC 605-45, sales tax amounts invoiced to our customers have been recorded on a net basis and are not included in our operating revenues. Deferred revenue primarily represents monthly cellular service access charges that are billed in advance by the Company. Stock-Based Compensation: We account for stock-based awards to employees in accordance with ASC 718, Compensation-Stock Compensation, ("ASC 718") and for stock based awards to non-employees in accordance with ASC 505-50, Equity, Equity-Based Payments to Non-Employees ("ASC 505-50"). Under both ASC 718 and ASC 505-50, we use a fair value based method to determine compensation for all arrangements where shares of stock or equity instruments are issued for compensation. For share option instruments issued, compensation cost is recognized ratably using the straight-line method over the expected vesting period. The Company estimates the fair value of employee stock options on the date of grant using the Black-Scholes model. The determination of fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of the awards and the actual and projected employee stock option exercise behaviors. The Company has elected to estimate the expected life of an award based on the SEC approved "simplified method". We calculated our expected volatility assumption required in the Black-Scholes model based on an average of the two previous fiscal year's daily historical volatility of our stock adjusted to exclude the top 10% daily high and low closing trading prices during the period measured. We will update these assumptions on at least an annual basis and on an interim basis if significant changes to the assumptions are warranted. 67 [ Back To TMCnet.com's Homepage ]